Opportunity for Investors in China's Mandate to Increase Use of Renewable Energy

Carbon Conscious

China seeks alternative, renewable energy sources

March 14, three days after the disastrous earthquake and tsunami pummeled northeastern Japan and spawned a nuclear crisis that is yet to be resolved, China ratiﬁed its 12th ﬁve-year plan — a plan that focuses on alternative and renewable energy sources and seems even more relevant in light of questions about nuclear safety and constrained energy supplies during the ﬁrst quarter of 2011.

Chain reaction

When plan details were released in November 2010, new energy, along with energy conservation and environmental protection, was identiﬁed as an industry critical to sustained economic development in China. Alternative-energy-related stocks soared in value following the announcement until the March 11 earthquake damaged Fukushima power plants, leading to radiation leaks. As a result, many countries have reviewed their nuclear energy programs. The Chinese government is likewise at a crossroads.

On March 16, the Chinese government suspended the approval process for new nuclear power plants and mandated comprehensive safety checks on existing plants. The state council also announced that it would review and adjust its plan to expand the nuclear power sector by 2020. We believe the council review will likely lead to new nuclear plant safety standards and potentially increase the capital required to meet those higher standards.

China is still in the early stages of nuclear power development and generates only 1.9% of its electricity using nuclear plants, compared with the world average of 14%. [1] With 13 nuclear power reactors in operation and 25 more are under construction, China should see its nuclear power capacity grow at an estimated compound annual rate of 23% from 2010 to 2020. [2]

A more thorough nuclear program may help meet one of China’s speciﬁc goals with the ﬁve-year plan — reducing carbon emissions per unit of gross domestic product (GDP) by 17%. The Chinese government intends to increase the use of new and alternative energy and reduce its reliance on coal-ﬁred power, which accounts for approximately 75% of generated electricity. While it remains to be seen if the expansion in nuclear capacity will be halted, China appears to be committed to stepping up its efforts in promoting the use of non-nuclear, environmentally sound alternatives, including solar, wind and hydro power. We believe these alternative energy sources should beneﬁt from supportive government policies.

Wind support

China already has numerous wind-power-related infrastructure projects in the pipeline, including plans to build six large inland wind-power farms and two in coastal regions. Offshore wind farms are also under consideration. Supportive measures have been introduced to the sector in recent years, such as enterprise income tax exemptions, a value-added tax refund (2008), a revised tariff system (2009) and mandatory wind energy purchases by power-grid-owning companies, which are required under the renewable energy law.

Solar system

Reports from China’s National Domestic Reform Commission indicate that China will aggressively push to meet global standards for alternative energy use. More solar energy facilities may be an effective way to meet alternative energy goals because China is one of the largest manufacturers of solar power components,nincluding polysilicon and solar cells. Supportive government measures are similar to those seen in the wind power sector, with additional subsidies on material and component-based projects.

Highlighting hydro

Already the world’s largest hydroelectric power producer, China will likely increase its hydroelectric power usage to reduce carbon emissions. So it’s no surprise the government has made increasing hydro power a priority considering its cost effectiveness and a massive hydroelectric resource such as the Three Gorges Dam in the Yangtze River, the world’s largest hydroelectric power station.

Implications for investors

Given the Chinese government’s mandate to increase the use of renewable energy, numerous opportunities for investors should be created across the alternative energy supply chain. For example, in China’s wind power industries — which can be divided into upstream (wind turbine component manufacturers), midstream (wind turbine manufacturers) and downstream (wind farm constructors or operators) sectors — we see multiple opportunities across the power equipment space because of the variety of companies involved in energy production. For integrated energy producers with diversiﬁed power segments, we believe fundamental research is critical to understanding business’ ﬁnancial composition and estimating stock values.

Share prices of select energy stocks have dropped because of weak investor sentiment in the sector. Our view, however, is that these prices ﬂuctuations may lead to relative value opportunities, and we will use our bottom-up stock picking capabilities to explore opportunities.

Important information

China is a high-risk asset class with potential for generating gains over the long term. In isolation, it should only be considered for use with more aggressive investors who have a long-term investment horizon and high tolerance for risk. Even then, the allocation is typically a small part of a broadly diversiﬁed portfolio. It can also be used as part of the discretionary portion of an asset allocation strategy.

Certain securities issued by companies in China may be less liquid, harder to sell and more volatile than many U.S. securities.

China-listed A-shares have limitations to repatriate fund assets back to the U.S. Political and economic conditions and changes in regulatory, tax or economic policy in China could signiﬁcantly affect the market in that country and surrounding or related countries.

Investing in developing countries can add additional risk, such as high rates of inﬂation or sharply devalued currencies against the U.S. dollar. Transaction costs are often higher, and there may be delays in settlement procedures.

Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, relative lack of information, relatively low market liquidity, and the potential lack of strict ﬁnancial and accounting controls and standards.

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